One of the most commonly-heard pieces of advice for novice traders is to work out a strategy using demo mode and/or backtesting and only enter the markets when you have proved your strategy to be profitable. Many newbie traders take this advice to heart, and spend large amounts of time developing elegant, profitable strategies that seem to be foolproof when used on historical data. These strategies often have impressive win-loss ratios, typically providing $3 of profits for every $1 of losses.
The next obvious step is to fund a forex trading account and take their winning strategy live. In theory, the strategy should work just as well in the live market as it does on the historical market, but in many cases, it doesn’t. Why not? Well, most of the time, the problem isn’t the strategy itself, but the person executing it. The psychology of trading with real money is markedly different to trading on a simulation, with emotions coming strongly into play. These emotions win out over the intellect, and the usual result is to force the trader into making bad moves at the wrong times.
The reason why purely mathematical approaches often don’t work in practice is that the markets are, by their very nature, irrational. They are composed of thousands of humans making individual decisions largely based on their own feelings about an ever-changing environment.
Most beginner traders believe that they can engineer a trading solution that can profit from this irrationality in an entirely rational way. But even if they do, they almost always fail to include the most important factor of all in their equations – their own humanity. And this is the key to successful trading – compensating for your own emotions and quirks.
Here is an example of how mathematics and psychology can come to blows in a trading environment. Conventional wisdom has it that traders should always have a 2:1 reward/risk ratio. This means that if the trader is only correct half of the time, they will be hugely successful over the long run. In fact, with this risk/reward ratio, the trader only has to be right 35% of the time in order to make money. However, this is trickier to achieve in practice than it is in theory.
Let’s say you decide to short GBP/USD at 1.7500 with a profit target of 1.7300 and a stop at 1.7600. Initially, the trade does well and the price moves in your direction, dropping through 1.7400 to 1.7360, seemingly on the way to your profit target of 1.7300. Then, at 1.7320, the price direction reverses and begins to creep back up slowly. Sticking to your strategy, you hang onto the trade, because you have decided on a 2:1 reward/risk ratio before the trade. However, the price keeps going up until it hits your stop at 1.7600.
In this example, you let a 180-pip profit turn into a 100-pip loss – effectively a 280-pip swing on your account. This is the kind of thing that can happen on the markets, and that is why many professional traders will scale out of their positions to take partial profits at lower levels than two times risk, which reduces their reward/risk ratio to 1.5 or lower. Obviously, this strategy is mathematically inferior, but in practice, it might prove to be a better compensation for your own psychology and the irrationality of the markets than any ‘perfect’ plan.